Is Everyone Wrong About the Cycle?

Is Everyone Wrong About the Cycle?

26 Apr 2018 - Martin Shenfield

Whilst volatility remains elevated & equity markets stuck in choppy trendless trading with ongoing negative breadth divergence, my colleague Dario Perkins revisits his thesis from last year that productivity growth & hence potential GDP has been underestimated & is as importantly now accelerating, especially in the US. If so this could alleviate any traditional late cycle pressures on corporate profit margins & extend further the current global expansion. (Nb our Global Leading Indicators are consolidating at a high level especially in the US & EA but not rolling over which suggests economic momentum should resume after a healthy pause. EMs & the open trade economies of Japan, Korea & Australia look a little more capped as the China slowdown starts to impact.

From our annual survey of client questions, it is clear most investors are looking for things that could go wrong with the global economy. Trade wars, inflation and geopolitics came out on top. But look hard and you could also spot a few examples of clients looking for reasons to be bullish. One idea kept reoccurring: productivity. As we explain in our response to the survey – to be published today – we agree this is a sensible place to look for potential upside surprises. And it could be a real game-changer. With labour markets tightening and most investors expecting an acceleration in wages, an improvement in productivity could alleviate any ‘late cycle’ pressures on profit margins and/or prices and keep the current global expansion going for longer than anyone currently expects. While this may sound outlandishly bullish given that the expansion has already lasted longer than anyone expected, the idea is actually not as farfetched as it sounds.

Reason 1: Nobody can explain why productivity has been so weak: As productivity slowed after the subprime crisis, it was only natural for economists to become more pessimistic about the supply side of the major economies. As a result, most have downgraded their estimates of underlying or ‘potential’ GDP. But this was probably an overreaction. History teaches us, for example, that productivity is more likely to revert to much longer-term trends rather than persist at recent growth rates. The chart above, taken from Jason Furman, shows that economists make smaller errors when they ignore the most recent outturns. At the same time, we know – thanks to another recent study – that estimates of potential GDP are often little more than moving averages. Again, economists are unduly influenced by the most recent data – the fact that productivity and trend growth rates are down tells us little about the future.

Reason 2: They can’t measure productivity anymore: National statisticians have struggled to incorporate the new digital economy. Consumption of digital products often does not involve a monetary transaction that corresponds to its value to consumers. Moreover, digital products are usually ‘non-rival’ and can be replicated at negligible cost. According to the national accounts, the IT sector’s share of the economy has been broadly stable for over a decade (even in price adjusted terms), despite massive increases in the use of digital equipment. This is surely wrong. It is also puzzling that official data show IT prices stopped falling around the time of the global financial crisis, another reason to think real output is being under-recorded.

Reason 3: The global capex revival: Investment has been fairly subdued in recent years, particularly when you take account of faster depreciation rates. Work by John Fernald, which decomposes GDP into contributions from factor efficiency plus contributions from labour and capital deepening, suggests this has also played an important role in the productivity slowdown. The good news is that investment spending is now picking up quite briskly, particularly in the US and Europe. Over time, this should also contribute to an improvement in output per hour.

Reason 4: New technologies: New technologies are driving the latest revival in global capex, with e.g. semi-conductor shipments booming all over the world. Again, this probably understates the true picture as there is also a great deal of investment in non-tangible capital that isn’t being recorded. These technologies also have the potential to boost productivity rates with industry experts expecting rapid advancements over the next 5-10 years. The obvious comparison is with the mid-1990s when the dotcom boom provided a powerful non-inflationary boost to US efficiency. Alan Greenspan spotted this trend early on and allowed the economy to run hotter than he might otherwise have done. Would Jeremy Powell et al do the same?

While controversial, there are some economists who have shaken off the post-2008 gloom and claim we are on the brink of another industrial leap forwards, on a par with what the late 1760s and the invention of steam power. After several decades in which digital technologies have improved at exponential growth rates – following Moore’s Law - we are now seeing powerful synergies that are finally beginning to unlock the full power of computing and digital technologies (hence the boom in robotics, machine learning, 3D printing, Big Data and the ‘sharing economy’). Perhaps this is wildly optimistic – maybe the rise of the machines will end badly – but it makes a refreshing change from continually chasing an elusive Phillips curve.